Sunday, April 19, 2015

The Risk of Being Right and Other Lessons



Introduction

I am dedicated to the mission of learning something every single day. Often I get a small insight into some relationship of minor long-term significance, but I never know its value either in the present or possibly in the future.

Was April 17, 2015 important?

One of my many advantages is that I am part of a loosely connected group of formerly senior securities analysts, portfolio managers, chief investment officers, institutional sales people and technical market analysts. We physically meet most months and we are in electronic communications daily. Last Friday, starting with the Chinese markets, global markets fell sharply. For a number of US portfolios the decline in one day wiped out the entire gain earned on a calendar year to date basis. I asked this group of former investment professionals if this drop was important or just a momentary blip. I broke the question into five parts which may or may not be related as follows:

1.  As we already knew many Chinese like to speculate, particularly with the new margin borrowing facilities. Can this kind of trading bring global markets down?

2.  Changing market regulation does not encourage liquidity when in short supply. Does the impact of various “To Big to Fail” measures to protect banks, and firms, (but not investors) actually raise transaction costs indirectly charged to investors? In periods of stress many deal with the absence of sufficient liquidity to bid for it by lowering offer prices contributing to the decline.

3.  There is no such thing as a totally fail-safe electronic system, no matter how many back ups. Those who were not too inconvenienced by the Bloomberg system being down for a few hours remembered how to use other devices; e.g., telephones, Reuters, and actual pencils and paper. Total reliance on new technology, as those of us why fly in planes know, can produce unhappy results. In the end and under stressed conditions the market has a place for human talent. Did the temporary halt of an electronic system materially hurt investors?

4.  The single day decline was not effectively captured by the volatility measures that some use as a measure of risk. Should investors not use volatility to measure the daily risk to their portfolios, but instead the depth of buy orders?

5.  Toward the end of the US trading day Friday, the size of the decline was cut significantly. Was it just a factor that there were not any new flows of sell orders hitting the market, or were there bargain hunters? Were buyers primarily long-term investors or just refreshed speculators?

Investment lessons from World War II

In a recent book review that covered the enormous contribution General George C. Marshall made to both the war effort and the European economic recovery after the war, there was a discussion that General Marshall, who at the time was US Army Chief of Staff, was not given the command to lead the allied forces for the European invasion.  There was no question by training and respect he was the logical choice, but FDR choose General Dwight Eisenhower*, a relatively junior officer for the job. There were lots of reasons for this choice, not the least is that Ike was more likely to be able to get along with the difficult British (then) General, later Field Marshall, Montgomery. Understanding this decision process I can appreciate Steve Jobs’ choice of Tim Cook to lead Apple** after he was not able to continue. Jobs did not choose someone with similar skills as his in terms of creative designs but rather someone who had a very different set of capabilities, which was the development and management of the supply chain.

* After the War and before he was President of the US, he became President of Columbia University where I graduated and received my commission in the USMC.

** I have holding in Apple.

Another lesson occurred to me last week. In reading the program for a concert by the Boston Symphony at Carnegie Hall that featured two pieces by Shostakovich, I learned how his music was evaluated by Stalin’s thought police/music critics when Stalin was alive and after his death. 

While not as draconian as Stalin’s control of the media and so called “intelligencia,” the current US Administration and much of the mainstream media have a single opinion on numerous issues including climate, inequality, economics, and foreign relations issues. Under varying political conditions it is reasonable to assume that popular opinion will change on some of these topics. The lesson for us as investors is that whenever there is a preponderance of opinion in one direction, it is likely to change in the future.  

No truer words

In his pensive column in this week's The Wall Street Journal, Jason Zweig quotes the late Peter Bernstein who I knew for many years. Peter said, “The riskiest moment is when you are right.” Not only does the correctness of the view breed arrogance, but it flies in the face of reality. No one is always right, excepting perhaps some favorite relatives. As with calling heads or tails on a flipped coin, after a correct call the odds on the next call being correct is 50/50 and certainly by subsequent calls there is substantial chances of being wrong. This awareness should prevent investors and manager selectors from being outcome-oriented. Picking winners eventually leads to losers. A better procedure is to pick managers that follow certain processes and procedures.

Two questions for the week:

1. What do you think Friday meant to your investments?
2. How do you pick winning managers?
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A. Michael Lipper, C.F.A.,
All Rights Reserved.
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Sunday, April 12, 2015

Unmeasured Risk



Introduction

Volatility, which appears to be rising, is a mathematical measure of past price movements. The risks I am concerned with are future price movements, particularly those which are reactions to future actions which were not occurring in the past. There is a myth that the past is easy to use as a platform from which to extrapolate the future. The problem is similar to thinking about an intricate piece of music. Just looking at the score gives one a relatively flat projection, whereas when I listen to a familiar piece of classical music, including Bernstein, not only do I hear a much fuller rendition than what my mind can conjure up but I detect differences when the incomparable New Jersey Symphony Orchestra* plays under different conductors and soloists. In a similar fashion if I just look at past performance of prices of securities and/or funds I miss the color that helps me think about the future. Staying with this analogy, when I learn that we are going to hear a new piece of music, I become a little hesitant as to whether not only am I going to appreciate it but whether I would like to hear it again. My fear, turning to the investment world, is in the not too distant future we may well be dealing with situations that are not part of the historical past that is measured by volatility.
*My wife Ruth is Co-Chair of the Orchestra and therefore I know I will like each concert.

What are we missing?

In my opinion we are not fully equipped to deal with:

(a) Interfaces of changing market structures,

(b) Regulations to protect the regulators,

(c) Uneven technologies with some participants having distinct advantages over both others and the regulators, and

(d) Securities that can be traded in many different marketplaces in different regulatory environments.

In addition, legal and accounting regulations have forced companies to disclose more facts, but for me that is like reading a musical score but not hearing what is important that the gifted musicians (executives) are trying to deliver. For example, Saturday night for me was devoted to reading the 186 page annual report of Goldman Sachs** and the 58 page SEC Form 10-Q on Jefferies (100% owned by Leucadia**.)  These are very different investment banking/broker/dealer/asset managers with significant but currently unmarketable holdings of private companies. The annual report did give more color about the qualitative elements as to how Goldman is managed, but for understandable reasons did not dwell as to its views on the long-term future, which is what our long-term investment is based. The 10-Q on Jefferies was a legal and accounting document with little on how the firm makes its critically important decisions. Both firms, as well as the rest of the financial community are currently devoting a lot of time, money and effort to avoid regulatory problems and not looking at their investors’ problems in deciding how an investment in these two very, very smart firms will fulfill investors’ long-term needs.
**Goldman Sachs and Leucadia are positions in our private financial services fund and Leucadia is personally owned.

What are my worries?

Due to regulations, members of the financial community have had to augment their equity capital to such a degree that return on equity for example, has dropped from 30% to 11% for Goldman Sachs, which is materially better than most of its peers. Not only has capital been bulked up, but prices for their services have narrowed in part due to this low interest rate environment and compliance costs, which have skyrocketed. What to me is the real risk is that in the past when important firms got in trouble, shotgun mergers were quickly put into place; e.g., Bear Stearns and Merrill Lynch. While the remaining firms have more capital, they probably do not have sufficient capital to be an immediate suitor when, not if, the next important firm gets in deep financial trouble.

If I am correct that there will be future crises and it will be difficult to pull off quick marriages, bond and stock prices will react way out of proportion to their past, and volatility measures will be out of kilter. This in turn can cause those that use volatility as a trigger to immediately sell major positions. If this happens at the same time that there is a major run on liquidity (perhaps caused by disappearing liquidity) in the bond market due to capital or other issues for owners of ETFs, including their approved participants, we could have a substantial fall in market prices.

This is not to scare you out of the market, but to warn you that volatility is an after-the-fact measure, often based on only three years of monthly data.

We are not retreating from our equity exposure. One of the reasons to introduce to you our timespan portfolio concept is that building reserves is the better part of valor.  We will probably do the most reserve building in our Replenishment Portfolio. This portfolio is designed to replace the capital that has been spent from the Operational Portfolio, which in turn is meant to carry the investor through two years of spending. The Replenishment Portfolio, with a typical time horizon, assumes over its five year life that there will be at least one down-market phase. The other two portfolios, Endowment and Legacy should invest any cash flow into longer term equity holdings in periods of turmoil.

What to do while waiting?

Just as I spent Saturday night studying various documents, you should in effect look through the tea-leaves. In doing so, go to the original rather than press accounts or summaries. Let me give you an example. Last Monday, NY Federal Reserve Bank President Bill Dudley gave an early morning talk to a business group at the New Jersey Performing Arts Center. Both television and print media covered Bill’s talk, but focused almost exclusively on the timing of the expected interest rate increase, which he finely danced around, as expected by me. However, if that was all you got out of his talk and Q&A session you missed the following salient points:

1.  Debt de-leveraging has ended at the household level.
2.  Real wage gains are coming.
3.  The winter weather was 25% worse than trend.
4.  His personal terminal projection without a great deal of confidence is 3.5% for the ten year period.
5.  Middle Income jobs have been hollowed out.
6.  Much of the student loan debt is poor quality as the students did not understand the complexities of the loan. Many were taking out loans for academic programs that did not offer large enough compensation, if they could find a job to be able to pay off their loans.
7.  There is currently not enough pressure on resource prices to induce inflation.
8.  There are some small bubbles out there now, but they are not a major worry.
9.  The key for him is that when rates go up it will be a slow gradual trend.

Think about the various summaries that you may have read about his talk and see how many of the points I listed made it into the articles or the mouths of the talking heads. Thus I think it is appropriate for me and other professional investors to keep looking through documents and listening carefully to what is being said.

Question of the Week: What of significance are you seeing/hearing that others miss? 
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A. Michael Lipper, C.F.A.,
All Rights Reserved.
Contact author for limited redistribution permission.

Sunday, April 5, 2015

“Sell in May”
But Maybe Not This Time



Introduction

After reading last week’s post, one of our perceptive readers asked about selling, specifically why not follow the old saying and “Sell in May and Go Away?” The decision whether to pursue this course should depend upon an understanding of the historical construct, the data, and the decision process.

History

Like with much of market knowledge this saying may have come from the City of London. (This square mile in London is where much of Britain’s financial transactions take place.) For centuries the gentry left their London homes to go to Bath or other resorts, which often had casino gambling as distinct from betting on the securities markets. This pattern was also followed in the US, pre air-conditioning, where many of the trading centers in the South were deemed to be unbearably hot in the late spring and summer.

Dow Jones Industrial Average Data

Air conditioning was already an important economic and personal comfort factor by 1985, some thirty years ago. If one looked at the DJIA performance since the first quarter of 1985, an interesting pattern appears in terms of quarterly performance. The first quarters’ average gain over the 30 years was +3.18%, followed by +2.92% average for the second quarters, -0.21% for the third quarters, and +4.44% for the fourth quarters.

My specific focus

The data does show there is a clear seasonal pattern but hardly enough of a trading difference to bear transaction costs, tax impacts, and the bother of trading. However, as both a professional money manager and an investor, I screen the data differently. Over the 30 years the annual average gain was 10.47% per year. Using 10% as a primary filter I looked for the exceptional quarter that produced moves that were equal to an annual average. In the first quarters there were 5 quarters of 10% or more gains and only one with a 10% loss. In the second quarters the ratio of 10% moves was 4 to the upside and 1 to the downside. Interestingly in the third quarters the ratio was 3 on the plus side and 5 negative results followed by a recovery in the fourth quarters of 6 positive and 2 negative. Therefore, if one could avoid owning stocks in the third quarters it would give support to the old saw.

However, there is another observation of the data and a different conclusion. As regular readers of these posts may know, I have speculated that we are due for a 20% or more gain within a year. My analysis shows that over this period we have enjoyed 20% or more annual gains 10 times and only one 10% loser in a year. Since the turn of this century or half of the period studied we have had only 2 years of 20% or more gains and both of these were more than +25%. In addition, the first quarter of 2015 produced a -0.26% move, thus there does not seem that there is much that the DJIA needs to correct by producing a 10% or more decline.

Decision process

I will not deny that based on historical odds investors should be preparing to reduce their equity commitments. This would fit under the general use of the portfolio manager’s guidelines which probably work around two thirds of the time. Often investors develop Investment Policy Statements (IPS) which are expected to guide the portfolio manage most of the time. Going outside of the IPS is permitted for sound reasons and could conceivably happen once every four years. (I would suggest that 2015 could be such a year.) Stricter controls of investments are found in rules, often built into contracts which could be abrogated under unusual circumstances. This could happen once every ten years. However, I don’t believe this is yet the case.  

Additional research elements

The Barron’s Confidence Index is pointing toward a more favorable stock market based on the spread of yields between high and intermediate quality bonds. Some competent conservative investors are advocating buying into the Russian stock market in their bargain hunting. One would only do this if one thought the base US and other major developed markets would remain ebullient.

The other drive that I perceive is the accelerating march of technology. Technology changes not only how we do things but also how we think. Professor Harry Atwater recently addressed a meeting of the East Coast Caltech Associates, where he spoke on “The Future of Renewable Energy.” His theme seems very bright and is based on an increase in solar battery efficiency.

While this may be debatable, he did quote a sage, saying that the Stone Age did not end because we ran out of rocks, but because humans discovered bronze tools. This was a wake-up call to me.  Our memory driven decision process should be overridden when new tools become usable. Thus, I need to redouble my efforts to understand the new tools that are coming on the market that question our past guidelines.  

Consequently,  I am not going to sell in May and go away.
__________    
Comment or email me a question to MikeLipper@Gmail.com .

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Copyright © 2008 - 2015
A. Michael Lipper, C.F.A.,
All Rights Reserved.
Contact author for limited redistribution permission.